CEO Compensation Research: Why You Want Rich People to Set Your Pay

All this talk about executive compensation reminded me of one of my favorite academic studies of CEO compensation. It was published in the late 1980's by my Stanford colleague Charles O'Reilly and two co-authors, one of whom -- Bud Crystal -- was a consultant who specialized in executive compensation.

They tracked 105 large firms and compared numerous predictors of how much the CEO was paid -- I am looking at the key tables in the article, and see these included number of employees, sales, return on equity, and assets. The interesting twist, however, was they hypothesized -- regardless of a firm's performance and size -- that the amount that outside directors on the compensation committee were paid on their own jobs would be a strong predictor of CEO pay. This is based on research on social comparison and anchoring -- the idea is that members of the compensation committee would use their own pay as a guide to help determine how much to pay the CEO -- and would be excessively swayed by this vivid information.

The results still amaze me: After controlling for traditional size and performance measures, the amount of money made outside directors, especially those on the compensation committee, had a huge effect on CEO pay. O'Reilly and his colleagues report that for every $100,000 that the average member of the compensation committee is paid, the CEO's pay goes up another $51,000 per year. Remember, these effects are independent of firm performance and size!

There are two lessons here. The first, as is well-documented, that there is little relationship between what CEOs get paid and firm performance, other -- less rational -- factors overwhelm it. See Pay Without Performance for the gory details. The second is that, if you want to make a lot of money, pick the richest and most highly paid people you can find to set your salary.

This is part of the problem that all those financial services CEO's now face. Obama's $400,000 salary is being bandied-about as the anchor, rather than the pay of the often stunningly wealthy people who have been sitting on their compensation committees for so long. Not only have their reputations suffered, the basic group dynamics and psychological principles they have to deal with are against them too -- they got merely well-to-do rather than fabulously wealthy people setting their pay now.

P.S. Charles also has a more recent study that seems to show that the more a firm pays the people on the compensation committee, the more the CEO gets paid! I quote "On the average,for every $1,000 more in fees that is given to the chair of the compensation committee,the cash compensation of the CEO is $1,746 higher." How is that for a rate of return? Talk about pay for play, or I guess it is pay for pay. This is from: O’Reilly, C.A. III and B.G. Main. 2007. Setting the CEO's Pay: It's More Than Simple Economics. Organizational Dynamics. 36(1):1-22

Bob I agree with your article 100% renumeration committees for executive pay are counter intuitive if they all award each other huge salaries, especially as often the reward is not warranted by a companies performance.

However I think since you wrote this article, in the UK at least, there is a slow change coming about. I noticed the CEO at Aviva stepped down after the shareholders rejected his pay package...

Its still not clear how you would go about changing the situation though, if you don’t pay your compensation experts you will not get good people, if you don’t pay well you wont get a good CEO, if you don’t get a good CEO share holder value falls wiping more value off the firm than the CEO and the compensation experts cost together!!!

CEO salaries have gone out of control and have jumped way above the rest of the population. I think companies are so keen to land THE person of their choice, they lose sight of the money they are spending.

On top of that a lot of them get paid off when they leave a company, even if they did a bad job.

It seems to me that there was another study that pointed out the people were more motivated by the size of their boss's salary than by their own potential bonus. Could it be that if you want to motivate subordinates more you pay yourself more. This racket is too cool! Almost Ponzi like. (Its good to be the king!!)

Great post Professor Sutton! What fascinates me (and perhaps slightly frightens me) about this discussion in the media is how rapidly we seem to be socializing and moralizing issues that we sorta didn't really care about for decades (should we have? I don't know).

Regarding the O'Reilly study, this is a fantastic study, though I don't think the results are surprising. In fact, I would hypothesize that this effect - that of a worker's compensation being correlated to his/her boss's - to be true at all levels of an organization, and not just at the top being the CEO and their board. And the fact that such a correlation exists might actually be somewhat expected - why would you ever expect that high paid managers would hire low paid employees or the reverse?

In that sense, I don't see anything "broken with the system" as some politicians claim. The CEO's job is to sell stuff to customers, give part of the revenue to employees as compensation, and give the rest of the profits to shareholders. The shareholders, represented by the board, can decide to pay the CEO whatever they deem to be fair in exchange for the profits he/she delivers to them.

Likewise, I don't see Obama's declaration to be broken as industry observers say - because the federal govt is now a shareholder, so if they want to pay someone less salary and it causes the CEO to quit or for talent to flee, the federal govt is as accountable for their actions as anyone else on the boards of these companies. Basically it all works itself out.

There are 2 things that concern me:

1) the organizational obfuscation that can occur when the link between profit generation & labor starts to weaken. Professor Sutton knows the companies I've worked for - and many of them were in the economically fortunate position to make money no matter what the employees really sorta did. This breeds a ton of dysfunction because people claim rights to higher and higher levels of compensation without really needed to justify it with results. The classic example of this phenomenon is of course govt itself - because everyone has to pay taxes irrespective of how well the govt is performing.

2) the misguided language of the Obama administration in dealing with what is now their portfolio holdings. When you become an investor, your job is to help and support companies to increase their shareholder value. Bashing them or their leadership to the public does not increase your shareholder value. If anything, it creates essentially the same emotional dynamic that any of us have when we have a jerk for a boss. So maybe a little less "I think wall street sucks" and a little more "I believe in the American financial system" would be useful for the morale of those companies as well as the morale of the country in general.

Bob, this is very interesting empirical work as compared the knee jerk: why those masters of the universe won't work for less.

But, what if we as society gain from CEO's pushing the compensation limit because we need to believe in the superstar thesis? A false but useful story, which propels us in society much the same way a placebo attends to our mental/physical health?

I loved that, in several of the articles on Obama's limits, the main dissenting opinion was from a compensation expert. Hmmm, I wonder if he was more concerned about his own salary than what's good for the companies he works for and the country he lives in. Then I read your postscript, which brought it all into clear focus. What a racket.